When the time comes for seed investment, it is important for entrepreneurs to understand the financing options available to them. The two types of initial seed funding that most young businesses choose are convertible notes or Simple Agreements for Future Equity (SAFE) notes. In this post we break down these financing structures in more detail for entrepreneurs and early-stage business owners.
What is a Convertible Note?
Generally, a convertible note is a form of debt that can be converted into future equity. Typically notes will carry an interest rate ranging from 2% - 8% with a conversion event set to occur 2-4 years after the notes are issued or once another round of financing occurs. Convertible notes serve as a simple way for a founder to get upfront capital that can be reinvested into the business to facilitate future growth and product development. For investors, a convertible note enables a highly valuable early stake in the company once the note principle and accrued interest convert to equity.
Mechanics of a Convertible Note
Convertible notes carry terms that must be weighed out both collectively and individually by an entrepreneur. While specific notes may carry more specialized terms, almost all convertible notes contain the following elements:
A convertible note carries a date at which point the note principle, plus accrued interest, must be paid back to the investor. Even if a conversion event such as a financing round is not reached, a company is still on the hook to repay the capital they borrowed.
Most convertible rates will include a discount to an investor on a future financing round. This discount compensates an investor for the risk they have incurred by lending money into an early-stage company.
A valuation cap sets the highest valuation for a note’s conversion price into equity. Investors like to get this number as low as possible so that they can receive the highest ownership percentage possible relative to their initial investment.
As an example, say a company issues a convertible note with a $2 million valuation cap and a 10% discount. During their Series A, the company is raising at a valuation of $4 million and $5 a share. With only the 10% discount, an investor’s note would convert at $4.50 a share. However, with a valuation cap, the note would convert at $2.50 a share and as a result juice the investor’s ownership percentage when compared to terms that don’t include a valuation cap.
Should You Issue a Convertible Note?
Convertible notes are great for early stage ventures who are unable to easily establish the value of their company or obtain access to more traditional financing means due to lack of established credit. By raising a convertible note round, a company can postpone the designation of a valuation while they further develop their business, find product market fit, and pinpoint early customers.
On the downside, because it is difficult to establish value for the company, an entrepreneur may not be able to assess the fairness of an issued note. Founders should also beware that a note with a high discount rate and low valuation cap can quickly chip into the ownership stake in their company. This can make future fundraising efforts more difficult and cannibalize ownership percentages of early employees.
What is a SAFE Note?
SAFE notes were first established by Y Combinator, a startup accelerator, as a way to make investments easier for both entrepreneurs and investors by standardizing investment terms and parameters. While SAFE notes have many of the same elements of a convertible note, they do have a few important differences. Most notably, a SAFE note is not a form of debt, rather it only provides the right for an investor to receive equity if a company reaches a conversion event. Because a SAFE note is not a form of debt, it has no maturity date, and therefore, does not require anything to be paid back if a conversion event does not occur. Removing this obligation can be a huge relief for entrepreneurs.
Similar to a convertible note, companies that attempt to access this type of funding without an established value for their business run the risk of ownership dilution if the SAFE notes contain aggressive discount rates or valuation caps. Alternatively, SAFE note investors would argue that these types of discounts and valuation caps are simply the appropriate compensation they deserve for taking on the investment risk of not being repaid for such an early-stage investment.
Comparing Convertible Notes vs. SAFE Notes
Do you know which Investment is right for you?
Deciding how you want your company to raise capital is a time-consuming but necessary process especially if your company is racing to quickly deliver a valuable product to customers. Regardless of which type of funding structure is chosen, make sure to socialize the terms, structure, investor expectations, and intended outcomes with both internal and external stakeholders. Building and maintaining a working financial model can also help inform these types of investment decisions by equipping business owners with a road map of how an investment may alter their ongoing operations and cash runway timeline.